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Crunch Time For V Cs

February 18, 2001

BusinessWeek e.biz -- Cover Story

Crunch Time for VCs

The industry is headed for a nasty shakeout that will hurt startups and the economy

Not long ago, Ronald C. Conway was probably the single most active venture capitalist on the planet. In just 20 months, the 49-year-old founder of Angel Investors, a Silicon Valley firm that seeds Internet startups, sank $160 million into 206 companies. His star-studded collection of investors includes Shaquille O'Neal, financier Herbert Allen, and eBay Inc. (EBAY) founder Pierre Omidyar. But now, Conway is calling it quits. He plans to shutter Angel Investors after the current two funds run their course. Although his overall returns will be strong, the past few months have wreaked havoc on his portfolio: Twenty of the companies he backed and an estimated $10 million in seed capital have been wiped out. "When the bubble burst, all hell broke loose," he says.

Hold on tight. Conway is a leading indicator of what lies ahead for the financiers of the Internet Age. After the biggest boom years ever, the venture-capital industry is headed for a gut-wrenching shakeout that will have repercussions throughout the economy. Think of the industry as an overinflated balloon. During the past five years, the number of venture firms more than doubled to 1,010, the number of companies financed surged 150%, to 5,380 last year, and the amount of money invested soared nearly tenfold to $103 billion, according to researcher Venture Economics.`Real debacle.' Now comes the pinprick. Many of the tech companies that have gone public over the past two years--most financed by venture firms--are proving to be downright terrible businesses. Venture-backed companies taken public in 2000 fell an average of 24% from their offering price, the first negative return since Venture Economics started keeping the statistics 15 years ago. Burned investors have slammed the door shut on the market for initial public offerings. After tech IPOs reached a peak of $8.7 billion during March of last year, there was not a single dollar raised in the public markets by such upstarts in January, according to Thomson Financial Securities Data.

With the stocks of their public companies tumbling and many of their seedlings running out of cash, venture firms are seeing their returns plunge. The average one-year return to venture funds has sunk from a high of 164% in 1999 to 43% in the first nine months of 2000. And Venture Economics is predicting that returns will dip into negative territory for the 2000 fourth quarter. "This has all the makings of a real debacle," says Jesse E. Reyes, a Venture Economics vice-president. "The industry will go through a downturn in performance, the number of companies invested in, the amount of money raised, and, ultimately, the number of firms that exist."

The fallout will be savage. Harvard Business School professor Morten T. Hansen estimates that at least half of the 200 U. S. incubators, which provide money like traditional venture firms along with office space and other administrative services, will go under within two years. Many of the thousand or so venture firms also will close their doors once their current funds are depleted. The first to go will be fair-weather newcomers who never established strong track records. Even veterans are feeling the pain. The 11-year-old Silicon Valley firm Hummer Winblad Venture Partners had to write off more than $44 million in one fund because of worthless investments in Net retailers Gazoontite, HomeGrocer.com (HOMG), and Pets.com (IPET), according to a report sent to limited partners that was obtained by BusinessWeek. Though that's just three companies out of 37 in the fund, the write-offs represent more money than the firm has lost in total since its founding. "It is an understatement to say how bad we feel about this," partner John Hummer wrote to his limited partners.

And the wreckage within the venture community is the least of it. Venture capital has a profound impact on the technology sector and the global economy. Venture money was the primary fuel that powered the commercialization of the Internet and other transformation technologies. Without those breakthroughs, the economy would not have enjoyed its supercharged run over the past decade. "The impact of venture capital on innovation is four to five times greater than corporate research and development," says Harvard B-school professor Joshua Lerner. Already, that flow of capital is contracting: Venture bucks slowed to $19.6 billion in the last quarter of 2000, down 26% from an average of $27 billion for the three preceding quarters, according to the National Venture Capital Assn. and Venture Economics. It's the largest percentage drop in funding since 1993--and the biggest overall dollar decline ever.

Even more worrisome is a shift in the kind of investments. Venture firms are backing away from risky, change-the-world companies and focusing on safer, more incremental technologies. "We're going to fund substantially fewer brave new world innovations no matter how good the ideas are," says Redpoint Ventures partner Geoffrey Y. Yang. He believes that TiVo Inc., a personalized-TV pioneer he backed in 1997, would likely not get funding today because it requires too much money to reach profitability. If this play-it-safe mood persists, it could undercut the tech development necessary to keep the economy healthy. "The coming five years will probably be less an era of radical inventions than the completion of ideas from the last couple of years," says Richard Shapero, a partner at Crosspoint Venture Partners.

How bad could it get? Venture Economics' research shows that investments are still being made at an $80 billion annual rate, sky-high for a business that was only $22 billion in 1998. But the historical evidence suggests that investments could drop much more. After the stock market crash of 1987, venture capital financings plunged 51%, from $5.2 billion in 1988 to $2.6 billion in 1991. The number of new companies receiving venture money dropped 61% to 283 during the downturn.

Venture capitalists are bracing for a downturn that could be just as dramatic. Though they hope that the second half of this year will brighten, most expect the gloom to continue at least through 2001. "One hundred billion was invested last year. Maybe $30 billion to $40 billion will be invested this year," predicts Oliver D. Curme, a partner at Battery Ventures. His reasoning: Most of the $100 billion in venture money was poured into flawed businesses that could collapse. "That will have a very chilling impact on the view of venture capitalists and entrepreneurs."

To make sure they don't wind up on the same junk heap as the collapsed companies, VC firms are launching a revolution within. No more cutting checks to inexperienced entrepreneurs with unproven business plans an hour after hearing their pitch. Gone, too, are the lemming-like stampedes to create copycat startups, such as the 150 finance sites launched in the last year alone. And say adios to the days when a venture capitalist sat on more than a dozen boards, spreading himself so thin that the startups suffered.Slash-and-burn missions. Now, venture firms are turning to innovative new strategies. They're doing everything from partnering with established money houses to streamlining internal operations to focusing their investments on specific tech niches. And when it comes to saving money, they're not hesitating to go on slash-and-burn missions within their own portfolios. Venture stalwart New Enterprise Associates, for example, recently recouped 60 cents on the dollar when it and several other investors forced the shutdown of the .Com Group, an online direct-marketing startup. It figured the company, which relied on online advertising for revenue, wasn't likely to flourish. So it was better to take the hit sooner rather than later.

It's those kinds of tough calls that will separate the winners from the losers. Certainly, Kleiner Perkins Caufield & Byers, NEA, and other established players with proven track records will be fine. In fact, there's likely to be a flight to quality where the best entrepreneurs will work only with the best VCs.

The selection process is beginning. Alfred J. Giuffrida, managing director at Horsley Bridge Partners Inc., an asset-management outfit in San Francisco with $6 billion under management, invests with more than 35 venture-capital firms in the U.S. Now Giuffrida says it's time to weed out the pros from the amateurs. Horsley Bridge will be paring back the number of firms that get its money, though not the overall dollar amount it invests. "All groups in venture don't have the skill in equal measure," says Giuffrida. "We're only going to look to invest with people who have core technology skills."

Adams Street Partners, a Chicago-based asset manager that invests in about 75 U.S. venture firms, is taking a different tack. It's shifting 5% of its $10 billion portfolio out of venture capital. Instead, it will put more money into distressed debt or buyout investments. "Venture capitalists need to get back to building companies as opposed to building stocks," says Adams Street CEO T. Bondurant French.

With investors pulling back, many venture capitalists are taking steps to conserve cash--both at their firms and at the companies they have funded. These days, a lot more money is being set aside to fund companies for longer periods of time. Wellesley, Mass.-based Battery Ventures, for instance, used to leave about 30% of the money in its funds for follow-on financings because so many companies were able to go public or get acquired at a handsome premium. Now, it reserves half of its fund for such investments. Battery says that will help make its latest fund last about two years instead of the 15 months it took to blow through the previous one.

The same gimlet-eye is being cast upon their investments. Consider EC Cubed Inc., a business-to-business software upstart in Westborough, Mass. It was on track to increase revenue by about 400% by the end of 2000. And even though the company expected to lose $26 million last year and take three years to achieve profitability, EC Cubed CEO Jeffrey Tognoni didn't fret. "Our venture capitalists and investment bankers told us that as long as we grew our top line 400%, we didn't have to worry about the bottom line," says Tognoni, who had already selected bankers to manage the company's expected IPO. "And we hit every quarter."

But it was not to be. In November, EC Cubed learned that three dot-com customers were going out of business and that several established companies were suddenly putting their orders on hold. Half of the startup's revenue was wiped out. Making matters worse was the 11th-hour pull-out of an investment consortium that would have sunk enough money into the company to give it time to revamp its business plan. The final straw came when Battery Ventures, the largest shareholder, decided to write off its $13 million investment in EC Cubed. Three weeks before Christmas, Tognoni was forced to send his 290 employees home. "It was the most abrupt change I've ever seen," he says.

Certainly, write-offs are nothing new in venture capital. Industry veterans routinely expect them. A rule of thumb has been that one-third of a firm's portfolio will tank completely, one-third will do fair-to-middlin', and the last third will yield at least one or two home runs that pay investors back and then some. The sizzling market of the past three years turned that upside down: Venture firms have been raking in millions while suffering few write-offs. Now, it's time to pay for the excesses of the past. VCs have slapped together so many companies that the failure rate for many of them over the next few years will likely be higher than the historical average of one-third.

That's why many venture capitalists are working more closely than ever with their startups to help them weather the storm. During the wildest times of the Internet craze, investors were spending far more time sniffing out new opportunities than they were managing deals already done. James W. Breyer, managing partner at Accel Partners, estimates that he and most of his colleagues were devoting only about a quarter of their time working with existing portfolio companies. The rest was spent competing for new deals. Now, he says, that ratio will probably flip back to the way it was pre-Internet mania.

And Breyer, like many others, is aiming to reduce his workload so he can pay more attention to his crop of startups. He has, for example, begun to cut back his board memberships from a high of 12, to 10, to focus on the most likely winners. Six months ago, Technology Crossover Ventures decreed that no partner at its firm could sit on more than eight boards. "I have no doubt that some companies suffered," Breyer says. "We dropped the ball on the level of advice and strategy we were providing."

Given that a greater proportion of companies in VCs' portfolios are needy, some firms are opting to bring in more management experts to help out. Redpoint has hired a so-called operating partner to assist startup CEOs who are having trouble navigating through the turbulence. Last year, Kleiner Perkins brought on a human-resources partner to assist companies with recruiting and employment. Softbank Technology Ventures has gone even further, offering its companies specialists in everything from business development to compensation.

Venture capitalists also are doing away with their lackadaisical approach to due diligence. Many VCs took shortcuts during the Net frenzy. They didn't check out entrepreneurs thoroughly. They didn't conduct deep industry research. And they didn't verify technologies. It took LogicTier Inc., a startup in San Mateo, Calif. that runs complex Web sites for businesses, just 20 minutes to get a commitment of funding from Kleiner Perkins last June.

The company had some cachet since its founder, Omar Ahmad, had been Webmaster at Netscape Communications Corp. And Kleiner Perkins knew a company like LogicTier offered something companies desperately needed. But even Ahmad didn't expect such a speedy response. "We were ecstatic," recalls Ahmad, who was so overcome that he got out of his car in the Kleiner Perkins parking lot to lay down on the ground and collect his thoughts.

Such spontaneous moments of joy are largely a thing of the past. Firm after firm is reemphasizing the need for discipline. Redpoint told its investors in a Jan. 15 letter that the firm will "be relentless on due diligence" going forward. Redpoint's Yang says that while the firm has always required at least two partners to sponsor any proposed deal, that rule was relaxed when competitive pressure made split-second decisions essential. Now, Redpoint will take its time before committing any capital. Silicon Valley's Crescendo Ventures has formed an internal eight-member research group whose mission is to evaluate new opportunities and understand the competitive landscape.

Perhaps the biggest changes taking place revolve around how venture capitalists run their own ships. While many have operated like mom-and-pop shops for years, VCs are starting to behave more like the well-run businesses they like to fund. It's a move that is long overdue, say experts, especially for a community that makes its living trying to build lasting, tightly-run enterprises. "If any one of a venture firms' portfolio companies were run the way they are, they would kill them," says Michael Homer, an investor in several high-profile venture funds.

Many venture firms, including Accel and Redpoint, have begun to hire chief operating officers to manage internal operations. And they are creating programs to address staff training and infrastructure issues. Battery Partners, arguably the largest venture firm focused on early-stage investing, is convinced that the most successful venture firms will be those that scale their businesses most efficiently. It has increased spending on its computer systems and facilities to cope with its growth from eight investing professionals in 1990 to 40 today. The firm plans to hire 12 people this year to bring its total staff headcount to 64 so it has the capacity to handle a larger number of investments down the road. "Our industry will be greatly dominated by firms that are institutional and have reached economies of scale," says Battery partner Thomas J. Crotty. "It's a dramatic change."

David Spreng, managing partner at Crescendo Ventures, couldn't agree more. His firm is planning to build a global franchise dedicated to early-stage investing in communications technologies. That's why Crescendo has created teams of specialists from different disciplines to work with each of its portfolio companies so that no partner is overwhelmed by the help any one company might need.

Firms are just as vigorous about rejiggering the way they make money during these tough economic times. Technology Crossover Ventures has doubled its funding of companies later in their developments, vs. backing more risky startups. It also has gone into the hedge-fund business, putting cash into the public markets with both long and short positions. TCV launched a $140 million fund devoted to public-market investing, which is up more than 30% for 2000, while the Nasdaq sunk 39%. Near-term, TCV wants to grow that fund to $500 million.

Accel, one of the most respected venture firms, is branching out, too. It hooked up with buyout king Kohlberg Kravis Roberts & Co. last year to integrate off- and online opportunities within Corporate America. The idea is to use KKR's vast network of contacts to identify and ultimately land clicks-and-bricks deals. Their $250 million fund, one of the few in the industry, already has backed ventures with McDonald's (MCD), Safeway (SWY), and Wal-Mart Stores (WMT). It's a risk, of course, but one that Accel's Breyer says is necessary to maintain returns of at least 25% to 35% in a down market. "We don't think business as usual alone will generate the returns we're looking for," says Breyer.

Of course, there are plenty of firms that believe business as usual is exactly what venture needs. They are welcoming a calmer investment environment and the exit of frothy, irrational market conditions. They say that companies backed now have a greater shot at success because they will have more time to build their business fundamentals and won't face pressure from rivals or bankers to put out products prematurely or to go public without a plan for profitability. "As difficult as it is, it's a healthy thing," says New Enterprise Associates partner C. Richard Kramlich, a veteran VC.

For venture capitalists, maybe. But not so for America's innovation engine. With so much focus on saving existing portfolios, few investors are willing to roll the dice on expensive, long-term projects whose returns could be many, many years away, if ever. No example of this unwillingness is more telling than that of Shapero's Crosspoint Venture Partners. A Silicon Valley outfit that backed lots of highfliers, including Brocade Communications Systems (BRCD), Ariba (ARBA), and Juniper Networks (JNPR), it is one of the best-performing firms around. One of its funds, raised in 1996, has turned $100 million into $4 billion. It also is considered to have a good eye for breakthrough technologies.

So it's not surprising that Crosspoint had little trouble getting commitments for a $1 billion fund it intended to launch late last year. But at the last minute, the firm did an about-face and informed investors that it wasn't going to take their money after all. Shapero explains that the uncertainties of the current stock market are driving the firm to adopt a more conservative stance, particularly when it comes to backing big ideas. He says that focusing on previous investments may be a smarter move right now than looking for new opportunities. "You can create the greatest companies known to man and still be stuck with small returns," says Shapero.

That's not to say that there still won't be great technologies emerging. Nor is it a verdict that venture capital will cease to be one of the best-performing asset classes around. It will be. But it is a stark reminder that even venture capital is a cyclical industry that is vulnerable to the whims of Wall Street. Not even Shaquille O'Neal or Herb Allen can change that.By Linda HimelsteinReturn to top